OTC Derivatives in the Land of the Rising Sun

Only the United States and Europe matter – at least that has been the view surrounding OTC derivatives reform. With CFTC Chairman Gary Gensler reiterating in a recent speech that a “significant majority” of OTC derivative trading is happening in the US and Europe, it is easy to see why Americans and Europeans have a narcissistic view.

If we closely regulate the majority of OTC derivative trading through only two major pieces of legislation, then little need exists to deal with the remainder – right? I can think of a number of governments, exchanges, clearinghouses and solution providers who would disagree.

Proposals currently in the works would create central clearing for interest rate swaps (IRS) in Japan, India and Korea and the same for credit default swaps (CDS) in Japan and Korea. Timetables are still to be determined. However, if thoughts have started to enter your head that Asia will simply wait to see what the West does before proceeding, you are dead wrong.

The Japanese House of Representatives on April 20 passed legislation that would modify the Financial Instruments and Exchange Law to enact mandates for central clearing, exchange execution and trade reporting. This only leaves a vote by the House of Councilors, one that many expect to happen by June 2010 to make the proposal law. Despite recent optimism from US lawmakers that they will have a bill passed before the end of spring 2010, it looks to me as if Japan may draw first blood in reforming the whipping boy of the credit crisis – the OTC derivative market.

Returning to my earlier point – that the amount of OTC derivative trading in Asia (and more specifically Japan) dwarfs that done in New York, London and other western financial centers – based on a recent report from the Bank of Japan, CDS outstanding notional in Japan is just over 1 trillion USD. That is only ~3% of the total market, and it is theoretically possible that a major swap dealer could have a larger position on its books, but $1 trillion is not to be ignored.

IRS outstanding notional in Japan is just under $30 trillion, a similar percentage of the total market as CDS. If we look at the total outstanding notional of IRS by currency, Yen-denominated IR derivatives account for 13% of the total. Based on that number alone, ignoring Japan when talking of global reform is shortsighted at best and quite possibly foolish.

First, there is the issue of systemic risk. The past few years have shown how interconnected the global financial markets are. If a major Japanese swap participant was to default, who is to say that the related counterparty risk might not bring down a major asset manager, pension fund or construction company?

Issues in Greece have demonstrated that actual money-at-risk does not have to be significant in relation to the size of the global economy to cause considerable disruption. Again, remember we are talking trillions – with a T. Once upon of time, that sounded like a lot of money.

Then there is the missed opportunity. In previous analysis of the OTC derivative market, TABB Group pointed out the huge revenue opportunity for everyone from clearinghouses to consultants. The same holds true in this case. Whether a market is $1 trillion or $300 trillion, infrastructure still needs to be built, legal documents created and signed, implementation plans made and contracts cleared. Competition is hot and heavy in the US and Europe, so looking East could very well provide substantial opportunities for those tuned-in enough to recognize them.

Some complications certainly do exist. Chief among them is the risk that liquidity in Japanese CDS contracts is too low for clearinghouses to accurately price and, therefore, risk manage the products. The inability to price derivatives contracts is likely what will keep many less standard products out of clearinghouse in the US and Europe, but Japan could face these problems on more vanilla index trades.

If a crisis was to erupt in Japan or other parts of Asia for that matter, it would impact the global economy as Japan is the third largest country in the world measured by GDP, behind only (you guessed it) the US and the European Union.

Question is, while all eyes are focused on Washington, D.C. and Brussels, who’s watching the Land of the Rising Sun?